The Valuation Question

March 1st, 2011 Mike

What’s my baby worth? Figuring that out is the biggest challenge entrepreneurs face when attracting investors. Many negotiations break down over this issue. The good news is that there are contractual mechanisms that can be used to resolve any disparities.

This article is written mainly from the perspective of a new company raising its initial capital from private investors.

There are more than a dozen ways in which you can arrive at a valuation for a business. My good friend and business mentor, Ian Campbell, wrote the book – Business Valuations – on this subject which is well recognized by the Chartered Business Valuators.

In arriving at a valuation, one needs to ask what the purpose of the valuation is. If it is for tax purposes – e.g. estate and succession planning, the valuation – and the method for producing a valuation – may be much different than a valuation offered by a buyer or investor.

Because this article focuses on valuation for purposes of attracting investors, the matter of “calculating” a value according to various accounting methodologies while interesting, will not be addressed because it really isn’t relevant. The idea of discounting a future series of cash flows to a present value may be interesting as well, but because of the risk, a very large discount rate (around 50%) has to be used. But, again, it’s not really that helpful (it may even work against you) in negotiating with investors.

When investors provide cash to a company, there is no question about what the value of that cash is worth. The present value of a dollar is a dollar. On the other hand, what is the present value of what the entrepreneurs are contributing to the new venture? Their ideas, intellectual property, developments to date, time and effort expended and future commitment of time and effort can be valued only on the basis of a future outcome.

In other words, if an entrepreneur can give investors a 100% guarantee that the business plan (i.e. the financial projections) can be achieved, the present value can be more readily determined notwithstanding a debate about what discount rate to use. However, we all know that business plans are rarely achieved exactly as planned. Sometimes the financial results are much better than anticipated and more often than not, the financial results are much poorer than expected.

Because young companies have no history, any future financial projections must be taken with a grain of salt. Very few companies achieve their projections. On the other hand, businesses with a history can be more readily valued on the basis of earnings multiples. A company that is growing modestly at 10% per year with earnings of $1 million per year could be valued at, say five times earnings, assuming (and that’s a big assumption) that these earnings will continue.

Even if the company beats its own projections, the metrics that are used to determine value, e.g. a multiple of earnings or multiple of sales, are unlikely to be the same in the future as they are today. Companies in a specific industry sector that are presently being valued at ten times their 12-month trailing revenues could see that multiple drop to five times by the time the company is acquired.

In any event, it is the future results – the financial performance primarily – that would determine the value of the business in the future and provide a basis for a current valuation.

The value will always be based on what someone will pay for the company – either shares in the company or the whole deal. That can never be predicted with certainty because market conditions will change. So rather than trying to predict (or debate) an outcome, let’s look at how an investment deal could be structured to ensure that all shareholders in a venture have a shot at an upside if the venture performs.

Another chapter deals with dividing the pie – figuring out how to divvy up the shares in a company among the participants. Bringing in outside investors is just figuring out how to further slice the pie.

Instead of asking, what’s the company worth, entrepreneurs should be asking, what’s the money worth? How important is that funding to the company? One could argue that without funding, the company is almost worthless.

Valuations are market driven. Back in the early 2000’s valuations of so-called dot-com companies were irrationally high. Start ups without business plans were commanding $5 million valuations. Now, the same types of companies are lucky to get a valuation of $1 million.

As a rule of thumb, it turns out that companies have to give up roughly one-third of the equity each time they do a financing. Why? Let’s say a start-up infotech company is seeking $500K. For the $500K, investors will want something between 25 and 40%. If they try to get more than that, they will end up running the company. While some want that, most don’t – they just want to go along for the ride. If they accept too small a stake, say 10%, it will not be a meaningful investment for them. Later, as the company grows and hits some milestones, it may raise more capital on a second round. Let’s say it needs $1 million. Again, it will likely have to dilute all current shareholders by a third. Now, the total value is $3 million. It sounds too simple, but it just happens to work out that way in practice.

What are Angels’ Expectations?

A commonly stated objective by business angels is that they want to make at least ten times (10X) their money as quickly as possible. In reality ths takes five to ten years. If you make 10X in 5 years, your annual compounded rate of return works out to 58%. If you make 10X in 10 years, that’s only 26%. But frankly, any returns in that range are great. The trouble is, how likely are such returns. Even if the company progresses well and executes its business plan, there are likely to be dilutive rounds due to additional financings and stock or option grants. A 10X company valuation in 5 to 10 years does not mean that early investors will acheive 10X. Indeed, they are more likely to achieve half or a third of that. This is often overlooked. The way to deal with this is by preparing a number of pro-forma cap table scenarios that show outcome valuations and shareholder payoffs.

Avoiding the Question

The question of what’s the business worth today can be avoided by using debt with strings attached. Instead of giving an investor an equity stake in the company, the company takes a loan from the investor. This loan is in the form of a convertible note or convertible debenture. This loan can be converted into shares of the company at some time in the future – typically when additional financing is required. A company may require $500K or so to get started and develop its idea but knows that it will need $1 to $2 million to then scale up sales. At that point, the new investors will likely negotiate and dictate the value. The first investors will at that time convert their loans to shares at a discount to the price being paid by investors in the current round. This discount is usually in the range of 10% to 25%. This gives the early investors a small reward for taking the early risk. But, is it really enough? One way to give the early investors an advantage is to “cap”, i.e. limit, on the conversion value. Example: If investors accept a $5 million valuation, but the convertible note is capped at $3 million, investors will be able to exchange their loan for shares at the lower valuation.

Another approach is to go with the founders’ valuation but make some of the shares vest according to performance. This is not done too often. However, it worked well for me as an investor. I said give me my valuation and if you hit your target of $1 million in sales in the first year, I’ll return a block of my shares to effectively give you your valuation. They hit the target and we were all happy.

What’s it worth tomorrow?

This is the question that needs to be answered. Valuations that are based on current market multiples overlook the fact that what is going to matter is tomorrow’s market. One thing is certain: the M&A multiples five years from now will be much different from today’s. We just don’t know if they’ll be better or worse.

The real killer, though, is competition. If the business case makes sense, you can bet that others will be pursuing the same opportunity. Can you perform better and faster? Case in point: RIM, the Blackberry guys. Because of competition from Samsung and Apple, the stock price dropped by 80% within one year.

Bottom Line: think about tomorrow’s value – what you need to achieve that (i.e. people and capital) and don’t worry too much about what you think the company is worth today. After all, giving up an extra 5% to a 10% shareholder gives him 50% more, but it costs you less than 6% (i.e. 1 – 85/90).